In today's global tax environment, there are a number of major forces now influencing a wide range of activities, processes, and perceptions of stakeholders – tax authorities, legislative bodies, non-governmental entities, taxpayers, and civil society around the globe. These key forces are creating megatrends in global tax controversy.
The number and size of audits, exams, and inquiries are dramatically increasing worldwide. Despite the OECD's call for coordinated action by nations in addressing base erosion and profit shifting, individual countries are not waiting for consensus to be reached and are acting unilaterally by engaging in a range of activities – from the use of aggressive audit tactics to the promulgation of new legislation or policies and procedures, as well as the implementation of other measures intended to protect their respective tax bases. Developed and emerging countries are also taking divergent positions on the interpretation of historical international tax standards. The arm's-length standard (arguably one of the most important concepts in international taxation) is under pressure, with some nations adopting positions openly inconsistent with the decades-old principle. Moreover, the debate continues as to whether tax administrations should have the authority to recharacterise bona fide arrangements and to disregard legal entities and binding agreements. In this unstable environment, the use of alternative dispute resolution options is gaining increasing popularity among both taxpayers and tax authorities as a means to resolve tax disputes in a cooperative manner. But, with nations acting more aggressively and taking diverse positions on basic fundamentals, fewer disputes are being successfully resolved in a timely, efficient, and effective manner, and the threat of double taxation is becoming more pervasive than ever. As a result, increasingly the use of litigation in certain territories is unfortunately viewed as a necessary option in key areas of tax controversy, particularly where the risk of double taxation is prominent.
Without a doubt, emerging megatrends in tax controversy will continue to shape the global tax environment and the actions of taxpayers and other stakeholders well into the foreseeable future.
Audits, inquiries, and exams continue to dramatically increase
Businesses increasingly operate globally, yet current international tax rules were developed in an era when cross border transactions were not as prominent. Consequently, a growing number of countries believe that today's tax rules leave gaps that may allow multinational corporations to engage in legal tax planning that inappropriately reduces tax revenues through the shifting of profits to locations with more favourable tax treatment. Furthermore, unprecedented political pressure continues to escalate based on populist rhetoric. It has become politically acceptable to single out multinational corporations for intense scrutiny - even to the extent they have become targets of a crackdown on "aggressive" tax planning and perceived deficiencies in the historical architecture supporting the international corporate tax system. Non-governmental organisations (NGOs) have raised issues related to tax fairness and 'tax morality', and several governments have held public hearings on issues related to the tax planning debate, double non-taxation, and tax evasion.
These developments led to a focus by the G20 countries on preventing tax evasion and aggressive tax planning. In response, the Organisation for Economic Cooperation and Development (OECD) initiated a well-publicised project addressing base erosion and profit shifting (BEPS). This project, combined with the related tax planning debate, is creating a turbulent environment, triggering an emerging megatrend of increased and aggressive tax audits and controversies. Many countries are engaging in vigorous audits and intensified enforcement activities as a means to address profit shifting that erodes their respective tax bases, while at the same time raising revenue to fill gaps in their budgets and to address austerity concerns.
Enhanced enforcement efforts are focused on implementing new strategies for identifying examination targets and adopting aggressive audit tactics, which include, but are not limited to, establishing special task force units, issuing onerous document and information requests, targeting specific industries, conducting tax raids, leveraging summons enforcement authority, requesting recorded interviews, using outside experts, and even resorting to the use of criminal enforcement options. Some countries are using 'tax police' and embarking on tax raids as they continue to aggressively scrutinise multinational corporations, particularly those active in the digital economy. These inspections may result in significant assessments, and in some cases, criminal liabilities. In addition, the Australian Tax Office has allotted significant funding to its tax compliance programme and is increasingly scrutinising multinationals operating in Australia through the use of a new, special task force. Other countries, such as Mexico, are reconsidering existing rulings and applying BEPS concepts to previous transactions involving business restructurings. The megatrend developing in this area involves dozens of developed and emerging countries adopting intensive risk assessment approaches and aggressive audit and enforcement practices to support existing and new rules that protect their tax base and perceived national interests.
Adoption of unilateral measures in reaction to BEPS is leading to more disputes
The OECD is leading the effort to address base erosion and profit shifting in a systematic manner. Following up its February 2013 BEPS Report, the OECD released a Coordinated Action Plan (the Action Plan), which addressed perceived flaws in the international tax rules and set forth precise action points and a specific two year timeline. The Action Plan cautioned that inaction regarding base erosion and profit shifting may have the deleterious effect of prompting unilateral actions by individual nations, resulting in global chaos and double taxation. This fear is becoming a reality. A number of countries are not waiting for the OECD to reconstruct the international tax system, rather these countries are using the attention created by the OECD's efforts to adopt interim measures to protect their respective tax bases. This includes unilateral actions ranging from the promulgation of new legislation or policies and procedures to engaging in intensified audit activity and other measures intended to address base erosion and profit shifting.
Many countries, for example, are enacting general anti-avoidance rules. Recently, Austria promulgated a rule that denies a deduction for interest and royalties paid to related parties in low-tax jurisdictions. Australia, in addition to enforcing its existing general anti-avoidance rules, released new transfer pricing guidelines and stricter debt funding rules. Other countries, such as France, are moving to develop one-off solutions to the taxation of the digital economy. These are the very issues that the OECD's Action Plan intends to address.
The emerging megatrend of unilateral measures in reaction to BEPS is problematic. Such measures are contributing to the proliferation of cross-border disputes and the resultant risk of double taxation. For multinational corporations, the process of tracking and managing the unilateral actions of individual countries and international organisations is becoming significantly difficult. In today's environment, it is not a matter of whether, but when multinational corporations will face tax audits and disputes as a direct result of these unilateral measures. Even more vexing, there is no consistent view about the positions adopted as a result of the unilateral measures, which leads to a lack of consensus and gives rise to an enhanced risk of double taxation.
Divergent opinions on historical international tax standards
For many decades, there has been general congruence among OECD countries over the meaning of historical international tax norms, such as the arm's-length standard and the definition of permanent establishments. There appears to be growing differences, however, between residence and source-based countries, which may lead to a divergence of views on basic taxing rights and fundamental tax principles. These differences inevitably will lead to more cross-border tax disputes.
The potential abandonment of the arm's-length standard is of great concern to many taxpayers and advisors. The OECD's Action Plan, which calls for country-by-country reporting, would require multinational corporations to provide information on their global allocation of income, economic activity, and taxes paid in accordance with a global template. This type of reporting is intended to serve as a risk assessment tool, as opposed to an enforcement mechanism, but the practical effect could lead to a demise of the arm's-length standard in favour of formulary apportionment and dramatically increased audit activity. The Action Plan further provides that it may be appropriate to go "beyond the arm's-length principle" and employ "special measures" where the arm's-length principle does not create results that address BEPS. Some observers believe these developments may signal that the OECD's support of the arm's-length principle is eroding and implementation of country-by-country reporting may lead to the use of formulas to allocate profits globally.
In addition, there are growing differences of view among countries on the need to respect transactions as structured by taxpayers and whether to impose limits on the ability of tax administrations to recharacterise bona fide arrangements. The issue of whether a government should have the ability to recharacterise valid transactions and substitute its judgment for the particular taxpayer's actual decisions dates back decades, but the BEPS environment has generated a new round in the historic debate. Chapter IX of the OECD guidelines provides that recharacterisation should occur only in unusual circumstances. But, concern is growing that there may be modifications to the international tax rules and the OECD's impending work on the allocation of profits for intangibles will likely add fuel to this debate. Until an international consensus is reached on the ability of tax administrations to recharacterise transactions, we will continue to see certain tax authorities assert the power to ignore risk allocations, recharacterise bona fide arrangements, disregard legal entities, and invalidate binding legal agreements. This will lead to another wave of uncertainty and further audits and disputes.
The growing disparity between interpretation and enforcement of historical international tax standards is a trend in non-OECD member countries. Authorities in emerging economies are known to assert expanded taxing jurisdiction based on location savings, people functions, and other theories arguing that multinationals should generate higher profits in their respective countries based on local market conditions. Certain emerging countries even claim that a local entity should be awarded a premium return – above and beyond an arm's-length return – for the benefits it receives as a result of local conditions, which include a skilled labour force and a large and growing consumer base. These countries are also adamant that their significantly large population and expanding middle class (as well as preferences for foreign brands) should equate to a local market premium. The position that unique local characteristics should be awarded a premium return in excess of arm's-length amounts contradicts traditional transfer pricing approaches published by the OECD and adopted by developed countries. Many commentators believe the OECD should avoid turning longstanding principles into a series of vague concepts that may be easily manipulated by nations to achieve their revenue needs.
Additionally, there is a concern that the OECD's forthcoming guidance may reflect more of the views of the mature and developed economies of the OECD member countries. Meanwhile, although non-member countries are participating in the BEPS discussion, they are using the United Nations as a conduit to develop their own approach to BEPS, as shown by the UN Practical Manual on Transfer Pricing for Developing Nations. This creates a danger that two tracks of work on BEPS may take diverse paths, and will add to the growing divide between developed and emerging countries on the interpretation and enforcement of international tax standards.
Divergent opinions on the interpretation of historical standards as well as the ability of governments to substitute their own opinion for a taxpayer's business judgment is an emerging megatrend in tax controversy that will continue to trigger more difficult and complex tax disputes.
Incidence of double (or multiple) taxation is becoming more problematic
One of the common themes arising in the current environment is that in the absence of coordinated multilateral action to achieve a uniform global tax system, individual nations will continue to add 'local flavour' to their interpretations of historical international tax rules, which will increasingly contribute to the lack of congruence on key tax issues, greater uncertainty, more controversy, and disputes left unresolved. This could undermine the existing consensus-based approach to international tax rules and replace them with inconsistent concepts leading to chaos. As a result, the risk of double taxation is unquestionably increasing.
OECD statistics confirm that the potential for double taxation is becoming more problematic as shown by the unprecedented levels of cross-border mutual agreement procedures (MAP) cases. For the 2012 tax year (the most recent year for which data is available), the OECD member countries reported a record high 4,061 open MAP cases, a 5.8% increase from 2011, and a 72.7% increase from 2006. At the same time, it is taking on average more than two years to resolve MAP cases. These OECD statistics provide dramatic evidence of the surge in tax audits and disputes among OECD member countries over the last six years. New MAP cases are increasing at a significant rate and the total inventory of open cross-border disputes is on the rise each year with no sign of slowing down.
The occurrence of "triangular cases" is also increasing in key areas. Triangular cases arise where three (or more) jurisdictions lay claim to the same item of income, or where tax assessments in one country have a correlative impact in two (or more) other jurisdictions. In these cases, bilateral income tax treaties do not operate effectively to resolve the tax controversies because those treaties generally do not facilitate the direct involvement of the other affected countries. Currently, there is no guidance as to how taxpayers and tax authorities should handle these multijurisdictional cases, and consequently, the existing dispute resolution mechanisms are not effective in such cases.
Importantly, the growing MAP case-load and the growing complexity of the issues faced are straining resources, prolonging resolution, and creating more political tension. In an era where tax budgets are tight and resources are light, efforts to hire competent staff are being met with obstacles. These factors will inevitably result in lengthy tax disputes and a heightened risk of double taxation – an emerging megatrend that concerns taxpayers most.
Development and use of alternative dispute resolution options
Taxpayers now face the strong likelihood that their tax arrangements will be examined and challenged in multiple jurisdictions, and, in turn, will be subjected to high compliance costs, penalties, and the looming risk of double taxation. As global tax controversy continues to increase, greater risks and uncertainty are emerging, and there is a renewed interest in pursuing alternative dispute resolution (ADR) options, such as pre-filing agreements, cooperative compliance programmes, administrative appeals, mediation, and arbitration. These pre-litigation approaches to dispute resolution require more transparency and robust disclosures by taxpayers, but they also provide an opportunity to create a cooperative environment between the parties and the resolution of matters in a more effective and efficient manner.
In an effort to gain better certainty upfront and to reduce the risk of audits on the back-end, use of pre-filing agreements and rulings (as well as cooperative compliance programmes) is increasing in certain territories. Multinational corporations are more frequently pursuing bilateral (or multilateral) advance pricing agreements (APAs) and other private rulings, which may act as an 'insurance policy' against future audits, risks, and exposures. (An unfortunate countertrend, however, is that several countries are retroactively revisiting such rulings and agreements, creating uncertainty over the binding nature and longevity of these arrangements.) There is also an increased interest in cooperative compliance programmes among revenue authorities and taxpayers, such as the Compliance Assurance Programme (CAP) in the US, the real-time working procedures in the UK, and horizontal monitoring in the Netherlands.
For those taxpayers in the midst of a tax dispute, the use of an administrative appeals process in certain countries is growing as a means to obtain relief without the risk and expense of litigation. In the context of mutual agreement procedures, the inclusion of mandatory binding arbitration provisions in tax treaties is also slowly gaining recognition in certain countries. The use of specified time limitations, independent arbitrators, and a baseball arbitration approach (winner-takes-all) are serving as forceful incentives to resolve cases early in the MAP process (actually, even before arbitration begins), as well as an incentive to resolve a number of cases where there is a substantial backlog.
These pre-litigation alternative dispute resolution options look increasingly appealing as an approach to reduce the unfavourable impact of tax disputes. Proactively, these options offer certainty in an uncertain environment, and reactively, such options work to resolve tax disputes in an effective and efficient manner. Hence, the megatrend emerging in this area relates to the continued development and refinement of ADR options in jurisdictions throughout the world and the proactive use of such options by multiple stakeholders.
Litigation (though rare) is growing in certain territories
As a result of these emerging megatrends, the global system for resolving cross-border disputes is under significant pressure, with few prospects for immediate relief. This is driving another megatrend in tax controversy – more frequent use of litigation as a method of last resort. It is inevitable that in certain cases both taxpayers and tax authorities must turn to the judicial system to bring consensus on critical issues and on concepts that lack uniformity. Further, as divergent positions on international tax rules are adopted by different territories, resolution of tax controversies becomes more difficult, the competent authority process becomes less effective, and litigation emerges as the primary option for dispute resolution. In fact, we are now seeing a substantial increase in the number of tax litigation cases in certain territories.
By far, transfer pricing is the predominant area of international tax law where issues are reaching the judiciary system for resolution. Because of the complexity and divergent views developed in transfer pricing cases, litigation is increasingly a necessary option for dispute resolution. This is particularly the case in the context of business restructurings, transfers and use of intangibles, and cost-sharing arrangements. Other key areas trending towards litigation include (but are not limited to) the definition of permanent establishments, debt/equity characterisation issues, allocation of management expenses, and indirect asset transfers.
Certain governments have hired specialists and have supported greater training and education of tax auditors and inspectors. This has led to issues under audit becoming increasingly complex and the resolution of those issues has become more protracted, resulting in litigation becoming inevitable in certain cases.
Many multinational corporations attempt to avoid litigation out of concern over reputational damage, the associated costs and expenses, and the uncertainty of the ultimate outcome. Nevertheless, as countries increasingly adopt divergent positions in key areas of international tax law, the necessity of litigation as 'the option of last resort' may increasingly become the only viable option for some taxpayers. These factors will lead taxpayers to proactively prepare defence files in key areas and for certain jurisdictions sooner rather than later, with the realisation that litigation may be a necessary option to resolve tax disputes on complex matters.
The bottom line
The nature of today's global tax environment is driving toward numerous emerging megatrends in tax controversy. Audits, exams, and inquiries are at record high levels. Certain countries are not waiting for the OECD's coordinated action to address BEPS issues. Instead, such countries are embarking on unilateral measures and taking divergent positions on historical international tax principles. Certain countries are asserting the ability to exercise their own judgment in recharacterising bona fide arrangements and to ignore legal entities and invalidate binding agreements. Emerging countries are advocating that local operations should earn a premium return to account for the unique aspects of their respective markets – positions that may be inconsistent with historic transfer pricing principles adopted in other jurisdictions – thereby leading to an enhanced threat of double taxation. This turbulent environment is encouraging taxpayers and tax authorities to consider the viability of pre-litigation alternative dispute resolution options. Indeed, the threat of double taxation is profound and the use of litigation is also growing in key areas of certain territories as an option of last resort. Now, more than ever, it is necessary to keep an eye on these emerging megatrends in global tax controversy, paying particular attention to how the impending BEPS guidance will impact these trends – or even create new megatrends confronting the international business community.